More Municipalities Bet on Bonds to Cover Pensions

Struggling to pay employee pensions, local governments are increasingly borrowing money to cover their obligations — exploiting a loophole in federal law that allows them to issue taxable bonds without seeking voter approval.

Oakland, Calif., took a bet on its pension fund that ended up costing the city an estimated $245 million — nearly a quarter of its annual budget. That hasn’t stopped the city from looking to try its luck one more time.

The bets are being made using an exotic but increasingly popular financial instrument known as a pension obligation bond. Cities, counties and states use the bonds to take out high-interest loans from private investors to plug shortfalls in their employee pension funds.

If the pension funds make smart investments with the borrowed money, the returns can help pay the interest due to borrowers and sometimes even spin off some extra cash to pay pension costs. If they don’t, the bonds can create additional costs for taxpayers, put the retirement funds of teachers and firefighters in jeopardy, and, in the worst-case scenario, force municipalities into bankruptcy.

Municipal finance experts are sounding alarms about the practice, saying that local elected officials are taking unnecessary risk because they are afraid to anger voters by raising taxes. There is also the risk of instigating powerful public employee unions if pensions are cut.

“There are communities that just do not want to make the hard choices, even though it means the choices in the future will be worse,” said Robert Doty, a municipal finance consultant in Sacramento, Calif. “They are just going to dig themselves deeper and deeper into a hole.”

Oakland provides the clearest example of the risks and the allure of these bonds.

The city is credited with issuing the first pension obligation bonds in the 1980s. Another set of pension bonds the city issued in 1997 have lost Oakland $245 million, according to the city auditor. Those losses have helped push the city administration to propose more than $200 million of new pension bonds in the coming months.

“One would think they would have learned,” said John Russo, the former city attorney who voted against the 1997 bonds when he was a city council member and resigned last year because of disagreements over the city’s budgeting. “This is a risk that may go horribly wrong.”

Another California municipality to encounter problems after issuing pension bonds is Stockton. The city issued $125 million in pension bonds in 2007, a third of which promptly disappeared when the market crashed in 2008. But Stockton is still on the hook for the annual interest payments, some $6 million, or about 75 percent of the city’s deficit this year. In late February, the city announced it was moving toward bankruptcy after determining it was unable to make the payments on these and other bonds.

Although local governments risk big losses from pension bonds, they carry profits with almost no risks for the law firms and banks that help arrange them. They aggressively market deals in which they get their fees up front, no matter what happens in the long term, according to several public officials.

“I was getting pitched the day after I arrived,” said Peter Taylor, the chief financial officer of the University of California.

Since 2008 the dollar amount of bonds issued has gone up each year, rising from $1.4 billion in 2009 to $3.6 billion in 2010 to $5.2 billion last year, an analysis by the Los Angeles Times shows. With cities and states expected to encounter growing difficulty in funding their pensions, many insiders expect more municipalities to try them out.

Just in the past few weeks, proposals to issue the bonds have come out of Cincinnati; Fort Lauderdale, Fla.; Hamden, Conn.; and the Democratic mayoral candidate in San Diego, Bob Filner, who said he would use the bonds to help the city’s budget crunch.

The argument for the bonds is almost always that they will fill a short-term budget hole and allow the city to maintain benefits for retirees. But market experts say the risks and long-term costs are frequently ignored.

Along with the interest rate payments and investment risks with which the bonds freight governments, they also provide another argument for opponents of public pensions, increasing the possibility that such benefits could be lost altogether.

“Municipalities find it attractive to think that there might be a free lunch — they can issue bonds and solve their problems,” said Jeff Esser, chief executive of the Government Finance Officers Association, which has issued an advisory cautioning its members against pension bonds. “Unfortunately, there is no free lunch.”

Pension obligation bonds are a product of the unusual way municipal pensions are funded. Unlike other divisions of local governments, which pay as they go, pension funds survive by taking annual payments from public employees and employers and investing that money to pay for future retirement benefits.

Some municipal finance officers realized in the 1980s that they could use these investment portfolios to do a form of Wall Street speculation that involves borrowing money at one rate with the hope of investing it and earning a higher rate.

Congress made it illegal in 1986 to issue normal tax-exempt municipal bonds for this type of speculation, but municipalities and their outside advisors realized they could get around this by issuing taxable bonds, like corporations. These bonds come with higher interest rates, but many local government officials have believed they could earn enough from investments to come out on top.

In California, Arnold Schwarzenegger lost a bid to issue pension bonds on the state level without voter approval when he was governor. But for most local governments, voter approval is not needed to issue the bonds because of their unique structure.

The bonds have worked out for some municipalities. Los Angeles County, for instance, issued $2.1 billion in pension bonds in 1994 that was promptly invested. In the boom years of the 1990s the value of the bonds shot up more than enough to pay off the cost of issuing them. But the current county treasurer, Marc Saladino, would never think of using them again.

“It’s only by the grace of God that the deal worked out for us,” Saladino said.

Many local governments have been willing to roll the dice because they have found themselves so far behind in funding retirement benefits for their employees.

The pension plan for California public school teachers currently has only 72 percent of the money that it estimates it will need to pay for the retirement benefits of the state’s teachers, down from 90 percent in 2007, according to the Pew Center on the States. It is doing better than other states, such as Illinois, where the teachers’ fund has only 48 percent of the money it will need, down from 63 percent before the financial crisis.

In Illinois, the state has struggled even to make the ongoing payments to the fund, much less make up the shortfall. For the past two years, the state has issued billions of dollars of pension bonds just to pay the immediate contribution to the pension fund.

The state will shell out $1.6 billion — or 5 percent of the state’s entire annual budget — just to pay off the interest on its pension bonds issued in the past decade, according to the Illinois Civic Federation. The bonds were issued with the hope of increasing the funding level of the pension fund, but that level has actually dropped.

In Oakland, the proposed pension bonds would help make up the shortfall in a fund for retired police and firefighters — benefits the city does not think it can reduce. If the bonds are issued the city will be able to breathe easily, but not for long.

Critics of the bonds say that municipalities are better off paying pension costs as they arise.

Doty, the municipal finance advisor, said municipalities often turn to pension bonds to avoid dealing with problems created decades ago.

“They really should have been paying all along. That’s really the bottom line,” Doty said. “Now there is an unwillingness to make the hard decisions. So instead they penalize future taxpayers.”Source: MCT Information Services